Numbers don’t lie, but they may not tell investors what they need to know. In the early years of the Vietnam War, U.S. Secretary of State Robert McNamara, a whiz kid recruited from Ford Motor Co., famously proclaimed, “Every quantitative measurement we have shows that we’re winning this war.”
The numbers said one thing; reality said something else.
For most investors, beta is the number they want to beat—or buy. It’s provided by an index. But beta is much richer and more complex. It’s not simply the number given by an index; and it can be deceptive.
So what is beta? In his 1955 doctoral dissertation, Harry Markowitz established the notion that a diversified portfolio of stocks could smooth out fluctuations among individual stocks, providing those stocks weren’t closely correlated. Markowitz’s three principal achievements were correlation analysis, diversification as a risk-dampening measure, and the definition of risk as volatility. Those achievements are summarized in the notion that there’s an efficient frontier beyond which diversification adds no boost to returns.
That was step one in modern portfolio theory. Step two was the articulation of beta. That goes back to the work of William Sharpe, among others. His Capital Asset Pricing Model established the market portfolio as the sum of all risky assets. And instead of analyzing the correlation of individual stocks to each other, his model looked at their correlation to the market portfolio.
Beta, said Sharpe, is the variability of an individual security’s returns against the market return—usually a benchmark such as the S&P 500. But in popular parlance, it’s come to stand in for the market return itself. CAPM involves more than that. Securities have to be evaluated against a risk-free asset like a treasury bill. The result is the capital markets line, which tracks a portfolio starting with a risk-free asset and slopes upward as riskier assets are introduced until it reaches a portfolio of risky assets only. The higher the risk, the higher the reward.
Simple theory; the reality is less so. “There are a few different ways to define beta, but really, it’s a description of the risk/return characteristics of a particular asset class,” says Michael Cooke, head of distribution, PowerShares Canada.
“It captures the performance characteristics of a particular market or asset class, for example equities or fixed income, and it is representative of the total invested capital in that particular market. So in theory it’s reflective of the beliefs and expectations of every market participant about the future prospects of individual securities, and in aggregate it reflects the market portfolio.”
Adds Rotman School of Finance professor Eric Kirzner, “A high-beta stock is expected to be more volatile than the market. When the market is strong, a high-beta stock [tends to] go up more than the market; and when the market is weak, a high-beta stock [tends to] go down more than the market.”
But, he notes, in practice, betas are not the best way to pick individual stocks.
“Beta is not a terrific measure for individual stocks. Although the Capital Asset Pricing Model shows that there is a strong relationship between return and volatility, betas are quite unstable for individual stocks. So using beta for individual stocks is probably not a very powerful tool.”
Kirzner says it works much better on a portfolio level when the beta of that portfolio can be benchmarked against a relevant index.
All the same, Tyler Mordy, director of research and co-CIO at HAHN Investment Stewards, comments, “I love what Andrew Lo at MIT says—that finance suffers from physics envy. We would like our models to be as predictive as they are in physics. You labour in this business for a while and you realize that humans run financial markets. So things aren’t as predictive.”
He finds price variability too restrictive a definition of risk. “If you think about short-term variability and you look back, even if you took a broad-based volatility measure five years ago […] volatility was heading lower right into the financial crisis.”
Beta may not be predictive on the risk front. But there are also problems on the return front, particularly when stock market beta is compared to the beta of other asset classes. Here, stocks are assumed to be riskier, and therefore should fetch a risk premium.
But, “if we’re going to capture that positive risk premium,” says Cooke, “we have to buy assets when they’re cheap and sell them when they are expensive. In fact, the opposite holds in the market-capitalization-based portfolio,” because it forces you to do the opposite.
The performance of emerging market bonds and stocks since 1994 offers a good example. Emerging-market stocks return 5.6% annualized, making it look like the additional risk was compensated.
“Well, in fact that wasn’t the case,” he notes. “Money-market instruments in emerging markets annualized 7.3% a year. In other words, I underperformed cash by 170 basis points per annum—a very stark example of a negative risk premium.”
The disappointing returns, Cooke says, stem from investors’ perception of beta. “A lot of foreign investors view emerging markets [through the lens of] a local bank, utility, cement manufacturer, pharmaceutical company, or energy company.”
So much so, Cooke says, that “The top 10 stocks in the Russian stock market count for 81% of the total market capitalization of the index. That wouldn’t be a problem if equity markets in general, and emerging markets in particular, were efficient. But history has shown they’re not.
“During the same period, not once did the top 10 stocks in any emerging market index collectively outperform the rest of the market over a subsequent five-year period. And yet that’s where the cap-weighted index is putting most of investors’ capital.”
So index construction may capture a stock’s market capitalization, but not its economic footprint or weight in the real economy (see “Russian heavyweight is overweight,” right).
There are two issues here. CAPM refers to all risky assets. But not all are represented on an investable index. One example would be privately held companies.
The other problem is finding a better representation of the economic weight of tradable companies that are components of an investable index.
“There’s something practitioners call the beta puzzle,” explains Mordy. “The Capital Asset Pricing Model suggests that higher-beta stocks should have higher returns. Empirical evidence suggests that it’s actually the opposite.”
Like Cooke, he argues capitalization-weighting is driven by high valuations, and valuations need more attention as a risk factor if investors are using beta as a proxy for risk.
“Value stocks tend to outperform growth stocks over the very long term because the valuation is reverting back to the mean and you get a free ride there,” says Mordy, “whereas growth stocks are typically pricing in that future growth and eventually revert back to more of a fair value. It’s the same concept with expensive assets in high-growth emerging markets.”
One response to the beta puzzle is to construct low-volatility portfolios. But Kirzner says the answer actually lies in asset allocation.
He says buying equities and looking to make them highly defensive is generally a questionable strategy. “You can go for lower beta and higher beta, but if you make it overly defensive why would you even be buying equities?” If you’re looking for an overly defensive position you’d be better served by increasing your fixed-income or cash components.
As Mordy puts it, “If we put in the equity component, I still want to have something that is going to perform close to the market. I don’t see the point of buying an equity portfolio with low expected returns and low volatility. I’d rather adjust the asset allocation.”
As for what you’re buying, even a poorly constructed index may work. On the other hand, a well-constructed index may be deceptive. “The problem with a lot of indices is that they can end up with very high concentration to individual stocks and sectors,” Kirzner says.
“The S&P/TSX might be a well-constructed index, but it’s not a particularly well-diversified index any longer. Buying the S&P/TSX, especially the 60, [means] 70% is in three sectors: energy, gold and the banks.”
That, arguably, dilutes Markowitz’s principle that diversification reduces risk—in the late 1990s and early 2000s, the TSX 60 became heavily weighted to just one stock, Nortel.
With concentration can come another problem. Beta has “got this backward-looking aspect to it, which doesn’t account for changes in the business cycle and macro-economic regime shifts,” Mordy points out. “A lot of the nose-to-the-grindstone stock-picker types would suggest you can ignore the big macro events and ignore bubbles and boom to bust.” He thinks stocks are in the third period of a secular bear market that began in 2000.
There are lots of ways beta may be an accurate measure of stocks and the market, but there’s much it does not answer. Ultimately, says Cooke, “Beta is not necessarily a great way to invest. It’s a misperception that’s been widely fostered, with the growing popularity of index products, but there’s more to indexing and building a market-based portfolio that still preserves the attributes investors are looking for: low cost, transparency, tax efficiency and liquidity.”
Scot Blythe is a Toronto-based financial writer.